Monday, June 24

Next bust sneaks a little closer

| By Jim Jubak

While the financial system appears inoculated against a global crisis, emerging markets are increasingly vulnerable. And there's at least one scenario in which a local crunch could trigger a global crisis.

How near is the next bust? I raised this question a month ago, and concluded . . . not very.

I haven't completely changed my mind, but . . .

• I'm still convinced that a bust of the magnitude of the global financial crisis that followed the Lehman Brothers bankruptcy is very unlikely.

• I hear the growls from the bears that say we're looking at a replay of the Asian currency crisis of 1997. I think a replay is very unlikely. Something like a smaller version of that crisis does seem to me to be more possible than it was a month ago, though. Emerging stock markets will bear the brunt of that smaller version -- and I don't think the decline in those markets is over yet.

• The biggest danger of a global crisis remains the eurozone banking system, and that danger is largely overlooked by the current market.

The Asian currency crisis of 1997 is a good place to start any examination of the risks in this market.

I don't see a replay of the crisis that took Thailand's stock market down 75% in 1997, that resulted in a 13.5% drop in Indonesia's GDP, or that required a $40 billion effort from the International Monetary Fund to stabilize the currencies of South Korea, Thailand and Indonesia. But I do see a way that a re-emergence of some of the conditions of that crisis could cost a different cast of characters; Brazil, India and Turkey are more likely participants in this version than South Korea or Indonesia are. And the cost could be a retreat of an additional 15% or 20% in stock prices.

In other words, a deep, painful but selective bear market in emerging stock markets rather than a global financial crisis.

Unless the world's central banks make huge errors, a crisis of that dimension wouldn't take down the global economy or global financial markets. And while I wouldn't rule out such errors, they are unlikely. The scenario we're looking at is one the central banks have been through before and that they have traditional tools to handle. But a crisis of that dimension, especially one with its echoes of 1997, is enough to produce confidence-shaking volatility that will test central banks, traders and investors.

Jim Jubak

The preconditions for the Asian currency crisis were the devaluation of the Chinese renminbi and the Japanese yen, along with an increase in U.S. interest rates. Those forces put pressure on the currencies and financial markets of countries, such as Thailand, that were running current-account deficits and were dependent on cash inflows from overseas investors to balance accounts. When money stopped flowing in and instead started flowing out and into the United States in order to take advantage of higher interest rates, the financial positions and currencies of these countries started to come unraveled.

At that point, some Asian countries had adopted fixed exchange rates in an effort to keep their export economies running at top speed by making sure that an appreciating currency didn't make the cost of Thai or Indonesian or Korean or Philippine goods more expensive for customers in the United States, Japan and China. The exchange rate with China was extremely sensitive, because many Southeast Asian companies exported semi-finished goods to China for further manufacturing and export to the United States and Europe.

But as cash flowed out of those economies and currencies, it quickly became not a question of preventing these currencies from appreciating but of preventing their collapse.

Traders can count; looking at the reserves of foreign exchange and the current-account deficits in those countries, they bet that central banks and governments wouldn't be able to defend the value of their currencies.

And indeed they couldn't. The Philippine peso, for example, went from 26 to the U.S. dollar in 1997 to 38 to the dollar in mid-1999. The Korean won and the Hong Kong dollar came under attack. The volatility was scary enough by itself: Hong Kong's Hang Seng stock market index fell 23% from Oct. 20 to Oct. 24, 1997. Finally, the Thai baht collapsed, taking the Thai stock market with it. Thai stocks fell 75% in 1997. With financial markets essentially shut and currencies collapsing, economies ground to a halt for a lack of financing. The Indonesian economy contracted by 13.5% in 1998.

The International Monetary Fund and global central banks finally stepped in to guarantee liquidity in those markets, but not before the crisis had spread to China. The Chinese government and the People's Bank of China had to take extraordinary steps to guarantee the solvency of the country's banks as a tide of bad loans swept through the economy.

With that history, you can see why raising the specter of the Asian currency crisis might be so scary right now.

There are echoes of the crisis in the drop in the yen that stretched from early November 2012 to mid-May. From Nov. 12 to May 16, the yen dropped 28.6%. Further, U.S. interest rates have started to rise: in the past month, the yield on 10-year U.S. Treasurys has climbed to 2.14% from 1.88%, an increase of 13.8%. Countries with chronic current-account deficits, such as Indonesia and India, have moved to slow outflows and defend their currencies by moves such as raising interest rates.

Certainly, spots of danger seem reminiscent of 1997. Indonesia and Turkey, two of the hottest emerging markets of 2012, are heavily dependent on foreign cash flows, and they've both seen big outflows of foreign cash in recent weeks. (Violence in the streets of Istanbul hasn't helped Turkish markets.) Brazil looks like it's in trouble, with cash flows out of the country picking up at the same time as the economy is slowing. That, of course, makes it hard for the Banco Central do Brasil to raise interest rates, although with inflation at 6.5% in May, near the top of the bank's range of 4.5% plus or minus two percentage points, the bank is likely to have to raise interest rates sooner rather than later no matter how slow the economy.

And, of course, Japan, with an estimated debt-to-gross domestic product ratio of 224% in 2012, is clearly nowhere near a sustainable level of debt.

But the differences with 1997 are significant. To me, they add up to volatility, further slowing in the global economy (and causing a significant drop in growth in some developing economies), a further drop in the price of emerging market stocks and big cash flows out of emerging market debt. But as painful as these market retreats as likely to be, they don't equal the kind of threat to global financial markets and economies we saw in the Asian currency crisis. (Not everyone agrees with me. You can get a good statement of the bear case in this interview with Albert Edwards of Societe Generale.)

What's different? Developing economies are, by and large, in better shape to weather a currency/overseas cash flow crisis than they were in 1997.

Asian currencies that were pegged to the dollar or to some basket of currencies in 1997 now float with relative freedom. That has made adjustment to changing market and economic conditions a gradual process rather than leaving any change to one big crisis. Foreign-exchange reserves are higher than they were in 1997. For example, as of May, Indonesia had foreign exchange reserves equal to 5.8 months of payments on its export bill, versus 3.9 months in 1997. The biggest swing is in South Korea, which had $329 billion in reserves as of April 2013, versus just $8.9 billion in December 1997.

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